Analysis of Investments and Management of Portfolios

by Keith C. Brown & Frank K. Reilly

Macroanalysis and Microvaluation of the Stock Market

The Components of Market Analysis Macromarket Analysis Microvaluation Analysis Valuation Using the Earnings Multiplier Approach Estimating Expected Earnings per Share Estimating the Stock Market Earnings Multiplier

Chapter 12

The Components of Market Analysis

This chapter is concerned with the market analysis portion of this process of the topdown, three-step market-industry-company investment process The two components:
The macroanalysis of the relationship between the aggregate securities markets and the aggregate economy The specific microvaluation of the stock market employing the valuation approaches
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Economic Activity and Security Markets

Stock Market as a Leading Indicator
Stock prices reflect expectations of earnings, dividends, and interest rates Stock market reacts to various leading indicator series Stock prices consistently turn before the economy does

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Economic Series and Stock Prices

Research has documented that peaks and troughs in stock prices tend to occur prior to peaks and troughs in the economy, Two broad categories of economic series
Sets of economic series suggested by the National Bureau of Economic Research Alternative monetary series influenced by the Federal Reserve

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Cyclical Indicator Approach to Forecasting the Economy

This approach contends that the aggregate economy expands and contracts in discernable periods Cyclical indicator categories Composite series and ratio of series Analytical Measures of Performance Surveys of Sentiment and Expectations

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Cyclical Indicator Categories

Leading Indicators: Economic series that usually reach peaks or troughs before corresponding peaks or troughs in aggregate economy activity Coincident Indicators: Economic series that have peaks and troughs that roughly coincide with the peaks and troughs in the business cycle

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Cyclical Indicator Categories

Lagging Indicators: Economic series that experience their peaks and troughs after those of the aggregate economy Selected Series: Economic series that do not fall into one of the three main groups such series as U.S. balance of payments and federal surplus or deficit See Exhibit 12.1 and 12.2

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Exhibit 12.1

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Exhibit 12.2

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Composite Series and Ratio of Series

A composite time series combines these economic series For example, the composite leading indicator index which is widely reported in the press each month as an indicator of the current and future state of the economy There also are composite coincident and lagging indicator series The ratio of these composite series can also been used in the analysis
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Analytical Measures of Performance

Diffusion Indexes
Trends Rates of change Direction of change Comparison with previous cycles

Rates of Change
Measures how quick a index series changes Similar to the diffusion index, the rate of change values for a series reaches peaks or troughs prior to the peak or trough in the aggregate series

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Limitations Of Cyclical Indicator Approach

False signals: This is when a series that is moving in one direction suddenly reverses and nullifies a prior signal Currency of the data and revisions: Some data series take time to be reported, but a bigger problem are revisions in data especially if the revision changes the direction implied by the original data Economic sectors not represented: Examples include the service sector, import-exports, data, and many international series
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Other Leading Indicator Series

The Center for International Business Conditions Research (CIBCR) at the Columbia Graduate School of Business:
Long-leading index leading employment index Leading inflation index International leading indicator series

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Surveys Of Sentiment and Expectations

Consumer expectations are considered relevant as the economy approaches cyclical turning points Two surveys of consumer expectations are reported monthly
The University of Michigan Consumer Sentiment Index the Conference Board Consumer Confidence Index

Other surveys of business expectations focus on firms capital spending or inventory investment plans
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Money Supply and the Economy

Friedman and Schwartz (1963) showed:
Declines in the rate of growth of the money supply have preceded business contraction Increases in the rate of growth of the money supply have preceded economic expansions

Friedman (1969) suggested:

A transmission mechanism through which changes in the growth rate of the money supply affect the aggregate economy Fed Reserve plays the central role through the open market operation
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Money Supply and Stock Prices

Studies examine whether changes in the growth rate of the money supply precede changes in stock prices
Earlier researches indicated a strong leading relationship between money supply changes and stock prices Later, others found that changes in the growth rate of the money supply consistently lagged stock returns Others found that stock prices adjust very quickly to unexpected changes in money supply growth
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Monetary Policy and Stock Returns

The recent focus had been on monetary policy rather that only money supply The relationship between some economic or company variables and stock returns can be significantly affected by the prevailing monetary environment
The term spread, dividend yield, and the default spread have different effects on stock returns

Monetary policy variables were significant predictors of future stock returns along with dividend yield.
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Inflation, Interest Rates, and Security Prices

Inflation and Interest Rates
Generally move together Investors are not good at predicting inflation See Exhibits 12.4 and 12.5

Inflation Rates and Bond Prices

Negative relationship More effect on longer term bonds

Inflation, Interest Rates and Stock Prices

Not direct and not consistent Effect varies over time
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Exhibit 12.4

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Exhibit 12.5

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Analysis of World Security Markets

Leading economic series are available for virtually all the developed countries, and the empirical relationships to the economy are quite similar to those of the United States Real GDP growth is typically consistent with what is implied by the leading series Other factors include
The monetary environment
The inflation outlook
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Microvaluation Analysis
The purpose is to estimate specific values for an aggregate stock market series Using the various valuation models presented in Chapter 11 with industry-wide data rather than companys data. Four Sets of Valuation Techniques
The Dividend Discount Model (DDM)

The Free Cash Flow to Equity Model (FCFE)

The Earnings Multiplier Technique Other Relative Valuation Ratios
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Estimating Expected Earnings Per Share

Estimating Gross Domestic Product Estimating Sales per Share for a Market Series Alternative Estimates of Corporate Net Profits Estimating Aggregate Operating Profit Margin Estimating Depreciation Expense Estimating Interest Expense Estimating the Tax Rate

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Estimating the Stock Market Earnings Multiplier

Determinants of the Earnings Multiplier Estimating the Required Rate of Return Estimating the Growth Rate of Dividends Estimating the Dividend-Payout Ratio

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Calculating an Estimate of the Value for the Market Series

It is important to understand the relevant variables and how they relate to the critical estimates of earnings per share and the earnings multiplier The two critical estimates that are necessary for both the cash flow models and the earnings multiplier approach are the required rate of return discount rate and the expected growth rate of earnings, cash flow, and dividends

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Using Other Relative Valuation Ratios

The price-to-book-value ratio (P/BV) The price-to-cash-flow ratio (P/CF) The price-to-sales ratio (P/S)

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Microvaluation of World Markets

Three Important Factors:
The basic valuation model and concepts apply globally While the models and concepts are the same, the input values can and will vary dramatically across countries The valuation of non-domestic markets will almost certainly be more onerous because of several additional variables or constraints that must be considered such as exchange rate risk and country or political risk
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The Internet Investments Online

http://www.morganstanley.com http://www.globalinsight.com http://www.yardeni.com http://www.whitehouse.gov/fsbr/esbr.html http://www.federalreserve.gov http://www.worldbankorg http://www.phil.frb.org/econ/forecast/index.html http://www.spglobal.com/index.html http://www.bis.org/cbanks.htm http://www.bankamerica.com/ http://www.nabe.org http://www.conference-board.org http://www.bea.doc.gov/bea/pubs.htm http://www.stats.bls.gov http://www.cbo.gov http://www.whitehouse.gov/cea/ http://www.gpoaccess.gov/indicators/browse.html http://www.census.gov/csd/qfr http://www.federalreserve.gov/pubs/bulletin

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